Thursday, December 31, 2009

Paul Krugman has described the first decade of the new millennium as being characterized by four zeros for the US economy - stagnant income for the typical family; zero job creation (even as population increased by 35 m), with private sector employment declining; zero gains for homeowners; and zero gains inthe stock markets. Further, the value of assetsper person, minus debts, adjusted for inflation fell from $200,076 by end-1999 to $173,684 by third quarter of 2009.

Job growth was essentially zero, as modest job creation from 2003 to 2007 wasn't enough to make up for two recessions in the decade. There has been zero net job creation since December 1999.

Unlike the US and other developed economies, equity markets in the emerging economies have, despite the events of the last two years, made substantial gains.

For cricket enthusiasts, the most gratifying development was the rise and rise of India's test match record graph (HT: Are you a left-arm Chinaman?)!

Though the BSE Sensex has been on steep upward curve, one only needs to remember that the rise this year has almost mirrored the equally spectacular collapse last year before drawing premature conclusions.

See this excellent interactive timeline financial history of the decade. And this of the build up to the sub-prime crisis here.

Update 2 (3/3/2010)

The most striking representation of the lost decade for the US comes from the Economist

Wednesday, December 30, 2009

Robert Shiller has long advocated issuing shares that have claims on a country's GDP. I have blogged earlier about Prof Shiller's proposal to issue paired macro securities (up-macro and down-macro) on the GDP of a country, with its value determined by the expected revenue streams or economic growth potential of that country, and paying out dividends in proportion to the performance of the country's GDP.

In a slight variation from the macros, along with Mark Kamstra, Shiller recently proposed that a country could issue sovereign securities called "trills", that commits them to paying shares with a coupon payment tied to the country's profit measured by its current dollar GDP. He describes trills thus,

"Each trill would represent one-trillionth of the country’s GDP. And each would pay in perpetuity, and in domestic currency, a quarterly dividend equal to a trillionth of the nation’s quarterly nominal GDP."

Trills issued with the full faith and credit of the respective governments would be a major new source of government funding and its dividend payouts would reflect the performance of the country's GDP. The value of the trills itself would depend on the expected dividend payouts, and would fluctuate depending on the changes in the country's future growth prospects. Financing government expenditures with trills would also play a role in stabilizing budget imbalances, since coupon payments fall in a recession with declining tax revenues.

Prof Shiller argues that trills could play a major role in remedying the imbalances in global capital flows. He writes,

"People who expect strong economic growth in a country would bid up the price of a claim on its GDP, creating a cheap source of funding for the issuing government. So a country with good investment prospects gets the resources at a low current cost. There would be no need for central bank machinations to try to correct global imbalances."

He also claims that trills, tied to nominal GDP, could protect its holders from erosion in value due to inflation, and thereby add a new dimension to portfolio diversification strategies, even as it enables them to partake a share in the country's GDP growth

"Now TIPS, or Treasury Inflation-Protected Securities, are offering disappointingly low yields, which may have to be raised to attract more investment. Trills, even at an ultralow dividend yield, would seem more exciting as an inflation-protected prospect, because they represent a share in future economic growth."

Shiller and Kamstra have proposed trills for both the United States and Canadian governments, and feel that there would be a lively appetite for it from institutional investors, public and private pension funds, as well as the individual investor.

However, trills, while attractive to indebted governments now, are likely to face some serious objections, especially given their perpetuity nature. David Merkel raises some of the issues here. Given the continuous actual and information shocks that an economy is likely to be exposed to, trills can be expected to be extremely volatile and thereby adding to the market volatility. As Merkel argues, the danger is that irresponsible governments will mindlessly issue trills to meet their immediate (and often revenue expenditure) needs and the future generations will end up making the perpetual annuity payments.

Tuesday, December 29, 2009

The rising government deficits across many countries and deep uncertainty about economic prospects raises questions about the approach to be adopted towards financing these debts, specifically the maturity choices of financing government debts. The dilemma is over the expected costs of debt service and the risk of facing a situation in which costs are much greater than forecast. Further, apart from determining the cost of financing the debt, it also determines the "shape of the yield curve, the extent of private sector maturity transformation, and the value of the currency (for instance if foreign lenders have different preferences over maturities relative to domestic lenders)".

The US treasury has been adopting a strategy of "exchanging short-term borrowings for long-term bonds", also in an effort to lower the real long term interest rates, to finance its deficits. Given the prevailing higher than expected long term rates (given the zero-bound in nominal short term rates), Paul Krugman has advocated that in addition to the Fed buying more long-term debt,the government can issue more short-term debt (T-Bills). He points to the fact that the overall borrowing by the non-financial sector hasn’t risen (and hence long term rates have not risen), since the surge in government borrowing has less than offset a plunge in private (long-term) borrowing (in view of the uncertain economic circumstances the private sector is fleeing into short-term securities).

In uncertain times, as Rajiv Sethi points out, since short-term debt becomes the preferred habitat for lenders, their rates typically tend to be lower than long term rates, which are inflated by their liquidity premium. This is another reason for preferring the financing of deficits with short term debt over long-term obligations. He also writes, "Other things equal, greater uncertainty (about future rates) should lengthen maturities. However, greater uncertainty will also steepen the yield curve and raise the expected costs of long-term (relative to short-term) financing, and this effect should reduce desired maturities."

Andy Harless (see also Rajiv Sethi's comments) too argues in favor of financing government debt through issuance of Bills by the Treasury. He makes an interesting case against borrowing long-term, so as to hedge against the possibility of unexpected increases in short term rates, and thereby reduce its risk of default. Any such unexpected increases would arise out of greater demand for short-term financing by private businesses and/or inflationary expectations taking hold, both of which would be signalling a sudden (unexpected!) economic recovery and therefore a welcome development. The recovery would also generate higher than expected revenues and reduced expenditure on fiscal stabilizers and other stimulus spending, thereby mitigating the higher costs of financing government debt.

In this context, Rajiv Sethi also draws attention to a paper by Joseph Gagnon, who advocates that the Fed purchase long term securities. Further, the Fed's purchases of long term securities, coupled with the Treaury's issuances of short term T-Bills, will ensure greater maturity diversification and also reduce the "vulnerability to unexpected fluctuations in interest rates".

Monday, December 28, 2009

The simplest intuitive case for the superiority of fiscal policy over monetary policy in retrieving a recession-hit economy, especially in the major economies, comes from the fundamental reality that the economy is ravaged with over-capacity across most sectors and private consumption demand is extremely weak. The only way out of this is to generate enough aggregate demand to first absorb the slack and in the process instill enough confidence among businesses to then invest in expanding capacity.

Monetary policy, through lower long term real interest rates, seeks to incentivize businesses to invest by lowering their cost of capital. But, as discussed above, the challenge is not to expand capacity as to fully utilize the existing capacity. The demand side stimulus by way of lower rates (on say hire purchase schemes for consumer durables etc) is marginal and takes effect with a lag. In contrast, fiscal policy, especially those that puts disposable income in the hands of people who are likely to spend it, has an immediate impact on boosting aggregate demand.

Monetary policy becomes even more ineffectual when the economy is facing the zero-bound interest rate and deflation has taken hold (or even when inflationary expectations are firmly under control). In the circumstances, the deflationary shock will lower short-term inflation expectations and therefore increase the real interest rate. Further, with nominal rates touching zero, the real interest rates cannot be lowered beyond a level and remains higher than desired. Even with massive purchases of long-term securities through quantitative easing, real interest rates on them will remain high.

Though economists like Brad De Long and Paul Krugman have advocated fixing a high enough inflation target to generate inflationary expectations and thereby put upward pressure on real long-term rates, the Fed Chairman Ben Bernanke fears that it could undermine the Central Bank's credibility. But the danger with such conservatism during such times is that the deflation may set in motion a self-fulfilling spiral of entrenching deflation and falling output, like that what gripped Japan in the nineties. It has also been suggested that Central Banks should communicate specific interest rate targets or bands, though its success is a function of their existing credibility. Further, the results of this has been mixed to give any meaningful lessons.

Charles T. Carlstrom and Andrea Pescatori of the Cleveland Fed advocate price-level targeting to demonstrate an unequivocal commitment to preventing deflation, "With a price-level target, the central bank commits to sticking to a given path for the level of prices over some horizon. If prices start rising faster than a pre-specified rate, policymakers must lower inflation in the future to get the price level back to the target. Similarly, if there is a deflationary shock, the central bank must inflate in the future because it has to bring the price level back up".

And about the different between inflation target and price-level target, they write,

"There is an important difference between an inflation target and a price-level target. An inflation target 'lets bygones be bygones', while a price-level target corrects for past misses. If prices fall on a year-over-year basis, a price-level target requires the central bank to reinflate prices until they are back to the target. An inflation target requires only that the rate of inflation be returned to its target rate from the present onward. A price-level target is essentially a promise that a deflationary shock today will increase inflation in the future and thus expected inflation today. This promise of future inflation will lower real interest rates even when short-term nominal rates are zero. Long-term inflation is still pinned down as it is with an inflation target."

Economists like PaulKrugman (and here, here, and here) have argued that at the zero-bound since banks’ cash reserves and short-term securities are perfect substitutes, banks have no incentive to lend the money out, and therefore any quantitative easing that focuses on purchasing short-term securities will fail. They simply substitute the cash they receive from the central bank for the securities they were holding in reserves, and therefore the supply of money in circulation is not affected. In other words, they attach no value whatsoever on any liquidity or safety advantage that might be had from holding assets in the form of cash.

Carlstrom and Pescatori however argue that even purchases of long term securities are not likely to yield the desired results in getting banks to lend money since the banks are more likely to sit on the cash they receive from the sales of those securities than lend them out. Even if there is some immediate impact by way of decrease on long-term interest rates (as evidenced in the yields of those securities), it is not likely to be large enough and lasting as long-term inflation expectations take hold.

Further, even if banks transact with the cash available, they are likely to use it to purchase short-term treasuries, whose relative risk-adjusted returns increase. Expectations on long term rates are also likely to keep banks invested in short-term instruments. The long-term interest rates are eventually determined by market fundamentals, namely long-term inflation expectations in conjunction with expected long-term economic growth, which are non-monetary factors. In any case, given the aforementioned excess capacity problems and weak consumer demand, the demand for borrowings is likely to be subdued.

Update 1Andy Harless feels that one way to have adequate fire power in central bank arsenal to respond to severe financial crisis induced deep recession is to "target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate". He argues that such an arrpoach ensures long term financial stability and minimizes the damage without relying on authorities to behave better or more presciently than they normally do behave.

Update 2Mark Thoma points to a working paper by Chris Sims about difficulties of policy at the zero lower bound - the difficulty of credible commitment to higher future inflation that is necessary in most New Keynesian models, the difficulty in achieving fiscal and monetary policy coordination, and the problems that may arise when the central bank takes quasi-fiscal actions

Update 3 (17/3/2010)Paul Krugman has a nice explanation of liquidity trap. He defines liquidity trap as one where conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero. Apart from the liquidity expansions, Central banks can also purchase longer-term government securities or other assets (so as to bring down long term rates), and they can try to raise their inflation targets in a credible way.

Update 4 (23/3/2010)More evidence of the claim that central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero.

A New York Fed assessment of the Fed's purchases of medium and long-term maturity assets since December 2008 by Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack find evidence that it led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than (normally expected) lower expectations of future short-term interest rates. It found that the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. Joe Gagnon writes,

"The reduction in long-term interest rates applies not only to Treasury securities, but also to mortgages and corporate bonds. Households buying and refinancing their homes took out mortgages worth over $2 trillion in 2009 and they will save about $11 billion in interest payments each year because of the lower interest rates. With interest rates remaining low for new borrowers in 2010, these benefits will continue to grow and will help to support consumer spending and economic recovery. Thanks to the low interest rate environment, corporate bond issuance (net of redemptions) reached a record $381 billion in 2009, helping to finance a turnaround in capital spending late last year that exceeded most private forecasts."

Gagnon had earlier advocated (see also this and this) that the "Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt."

Update 5 (13/7/2010)Paul Krugman advocates buying longer-term government debt and private sector debts, moving expectations by announcing intent to keep interest rates low for a long time, raising long-term inflation target. All this would "convince the private sector that borrowing is a good idea and hoarding cash a mistake".

Scott Sumner too feels that central banks have insufficiently boosted expectations for businesses to have enough confidence to start making investments.

1. The Fed could signal to the markets that it intended to keep its benchmark federal funds rate at zero to 0.25% for even longer than the "extended period" the Fed has been projecting.

2. The Fed could lower the interest rate it pays on excess reserves, the deposits that banks keep at the Fed in excess of what they are required to keep, from its current level of 0.25%.

3. The Fed could again expand the size of its balance sheet, which stands at about $2.3 trillion, by buying additional Treasury debts or mortgage-backed securities, or even other classes of assets, like municipal bonds.

4. On a smaller scale, the Fed could also reinvest the cash it received when the underlying principal on mortgage bonds on its books was repaid, a step that would also keep the Fed’s balance sheet from shrinking.

Bernanke has this speech outlining his monetary policy options if further accommodation is called for - conducting additional purchases of longer-term securities, modifying the Committee’s communication, and reducing the interest paid on excess reserves.

Sunday, December 27, 2009

The International Air Transport Association estimates that the world’s airline industry will lose a combined $11 billion this year and $5.6 billion next year. Interestingly, while all Airlines have been dropping routes, shedding employees and scrapping aircraft orders, those from developed and emerging (especially Asian) economies have been responding in contrasting ways to the crisis.

In contrast, as NYT reports, many Asian carriers have been investing on improving service standards, especially for the business class travellers. These include more diversity in in-flight entertainment, more comfort and luxury both at the airport lounges and inside, greater variety in food and drinks and so on.

Asian airlines’ obsession with service shows through in the quality rankings of Skytrax, a consulting firm based in London - five of the six airlines in Skytrax’s five-star category are based in the Asia-Pacific region, as are nearly half of the 27 carriers that hold four stars, only a few four-star carriers are North American and fewer than 10 are European.

The difference in approaches among arilines are an example of how cultural factors and specific market structures are critical towards determining business strategies. As the Times reports, Asian airline passengers expect top service because it is part of the region’s cultural makeup and because no-frills budget carriers are not as established here yet. People are yet to experience the lows of no-frills carriers.

Commercially, more than the US and European carriers, a larger share of the margins and revenues in Asia come from the high-end travellers, and none can afford to be the first to cut corners when it comes to service levels. Further, the top end of the market is the fastest growing segment of airline market in many countries, in terms of revenues and profitability, and there is naturally intense competition to capture new and retain old customers in these segments.

In Kerala there is an acute shortage of people who can climb coconut trees amd pluck coconuts, so much so that the Kerala government even announced an international design competition to develop commercial coconut picking machines.

And both jobs are highly remunerative. A coconut plucker in present day Kerala can make Rs 300-500 a day for a couple of hours work. Similarly, the cost of a basic one-day job by two blade climbers in California starts at $2,000!

In California, the free-wheeling spirit of capitalist America has tapped into the supply of recreational climbers to incentivize them into cleaning and repairing blades. Is there a similar market in Kerala, as part of tourist packages to Kuttanad? How does "coconut tree climbing adventure tourism" sound???

Saturday, December 26, 2009

We are used to having investment banks charging their clients large sums for maanging their investments. But among the many wonders of the modern financial engineering, which rose to prominence as the sub-prime mortgage bubble got inflated and subsequently burst, were instruments that ended up forcing investors to pay their fund managers for even losing their investments! Heads I win, tails I win!

Times has this nice story of how Wall Street giants like Goldman Sachs placed unusually heavy bets against mortgage securities (shorting them), even as it was packaging and peddling securities based on them, like Synthetic Collateralized Debt Obligations (CDOs), to its clients.

CDOs are made up of credit default swaps (CDS) that insure against default of mortgage bonds (as against the bonds themselves in case of normal CDOs). Sellers of CDS would receive regular payments as long as the underlying mortgage securities stayed healthy. Sellers in turn sold them off to Wall Street investment banks, who packaged them off as synthetic CDOs to their large clients. The proprietary trading desk of these firms then bet against the mortgage bonds by themselves purchasing insurance in the form of CDS and paying premiums for it. When the mortgages sour, the investors lost the right to their investments even as the swaps pay out to those who bet against them. Exercise the swaps, liquidate the short positions on these bonds by market purchases, and book handsome windfall profits! In other words, your clients pay you for losing their investments!!

Unlike conventional CDOs, where investors took losses only under extreme credit events, when the underlying mortgages defaulted or their issuers went bankrupt, the synthetic CDO holders would have to make payments to short sellers under less onerous outcomes, or 'triggers' like a ratings downgrade on a bond. This meant that anyone who bet against such CDOs could collect on the bet more easily. Regulations were progressively gamed to favor those betting against these CDOs.

At the peak of the sub-prime mortgage bubble, even as its trading and portfolio management arm was selling synthetic CDOs to unsuspecting clients, carried away by the "irrational exuberance" of the boom, the proprietary trading desks (which uses its own capital) of firms like Goldman Sachs were betting against the same underlying instruments by shorting them. When the bubble burst, the investors were left holding suckers while Goldman made windfall gains on its bets.

Goldman's version of such mortgage linked securities, whose underlying was not the mortgage bonds but the related CDS's, were called Abacus. The NYT story nicely captures how Goldman's traders were aggressively selling Abacus, trying to make its assets more attractive than they actually were, without encouraging their clients to hedge agianst these instruments going bad.

In effect, these firms were simultaneously selling securities to customers and shorting them because they believed they were going to default - "buy protection against an event that you have a hand in causing". Incidentally, worried about a housing bubble, Goldman Sachs had decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly. One of the sources of the Times report put such instruments in perspective,

"When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson".

Update 1From John Cassidy's excellent chronicle of the sub-prime crisis.

"CDS aren't really swaps at all, they should be called credit insurance contracts... In 1997, a group of math whizzes in Morgan's derivatives department took $9.7 bn in loans that it had issued to about 300 corporations, placed them in a SIV, and distributed tranches of the SPV to investors. This sounds like routine securitization, but it came with a twist. The investors - insurance companies and other banks, mainly - didn't get to own the loans, which remained on Morgan's books; they merely agreed to take on the risk of Morgan's borrowers defaulting.

In return, Morgan agreed to pay them what were effectively insurance premiums. As long as the borrowers kept making their interest and principal payments, the investors would receive a steady stream of income - some $700 m a year in total. But if some of the borrowers defaulted, the owners of the SPV stood to make up the full value of the loans. These mutual obligations were defined in legal agreements, which were called CDS.

The deal accomplished several things : it removed $9.7 bn in credit risks from Morgan's balance sheet, freeing up capital the firmm could use elsewhere; it transferred these risks to other financial institutions that had more of an appetite for them; and it created securities that could be traded, this allowing investors to get exposure to an asset class - bank loans - that they had previously been excluded from."

Update 1It is widely acknowledged that unregulated, over-the-counter (OTC) derivatives like an option to buy a stock in the future at a fixed price set today and credit-default swaps (a form of insurance against the future default of a bond) played a critical role in the sub-prime bubble. Now Goldman's CEO Lloyd Blankfein has himself acknowledged the need to regulate them by standardizing the contracts and making them trade in exchanges.

William Cohan has a nice account of how Goldman Sachs made massive money by betting against the sub-prime mortgages, while AIG lost money betting against sub-prime mortgages falling.

Update 2 (6/11/2011)

Citigroup sold securities to investors and then turned around and shorted these same securities. The bank not only believed the securities would decline in value, but it actually spent its own money to make money off the terrible product it had sold to customers. The transaction involved a $1 billion portfolio of mortgage-related investments, many of which were handpicked for the portfolio by Citigroup without telling investors of its role or that it had made bets that the investments would fall in value. Bruce Judson has call it a classic swindle.

The SEC recently announced a $285 million dollar civil settlement with Citigroup involving both compensating the victims and penalizing the firm.

The unfortunate aspect of this settlement was the relatively light nature of the punishment given to Citigroup despite this malafide transaction being clearly established. The $95 mn fine is a relative pittance for Citigroup, whose Q3 2011 profits are estimated to be $3.8 bn. As Judson writes, "these settlements have become simply a "cost of doing business" for our increasingly monopolized financial sector and are unlikely to impact its behavior".

Friday, December 25, 2009

Ben Bernanke famously attributed the global macroeconomic imbalances of the last fifteen years to a global "savings glut" whose fountainhead was China. The most damaging consequence of this "savings glut" was the sub-prime bubble in Wall Street. A less discussed, hitherto benign, result has been a massive "capacity glut" in the Chinese manufacturing machine. This "capacity glut" has been facilitated by two factors - export and build forex reserves and keep domestic consumption depressed.

Chastened by the events that precipitated the East Asian economic crisis of the late nineties, the Chinese government adopted a single-minded strategy of building up massive foreign exchange reserves by turning the country into the factory of the world and exporting the major share of production. Policies were designed to facilitate manufacturing production - tax and other fiscal concessions, cheap (often free) electricity and water, cheap and unlimited credit, limited licensing and other regulatory restrictions and so on. And all of this was driven by local party bosses, intent on generating GDP growth in their jurisdictions, regardless of how it is achieved.

And enabling this was complementary set of policies that contributed towards incentivizing savings and discouraging domestic consumption. The renminbi was tagged to dollar and aggressive exchange rate interventions to keep currency under-valued meant that imports stayed expensive. The absence of adequate health care, pensionary, and social safety nets, especially for the armies of people laid off from the old state owned units and who subsequently found work in the town and village enterprises, have meant that people have little choice but to save for the rainy day. The result was the lowest private consumption rate (35%) and one of the highest savings rate among all major economies.

The global economic recession has left the export market weak and the Chinese domestic market unwilling or unable to step in, amplifying the "capacity glut". And Mark DeWeaver has this to write about the results of the dramatic capacity explosion

"Mao’s dream of catching up with the rest of the world has been realized, albeit a bit behind schedule, not only in steel making, where annual capacity has reached 660 million tons, but in many other sectors as well. In 2008, China ranked first in steel (about half of world production), cement (also about half), aluminum (about 40%), and glass (31%)... The country topped the US in auto production in 2009, and remains second only to South Korea in shipbuilding, with 36% of global capacity...

Based on the National Development and Reform Commission (NDRC) figures, 2008 capacity utilization rates were just 76% for steel, 75% for cement, 73% for aluminum, 88% for flat glass, 40% for methanol, and 20% for poly-crystalline silicon (a key raw material for solar cells). The current project pipeline also implies less than 50% utilization for wind-power equipment manufacturers in 2010...

If simply leading the world in output is the goal, the Chairman’s vision has been resoundingly vindicated. But if product quality, environmental protection, and economic efficiency are important as well, this state of affairs is little short of nightmarish."

And to compound the problem, the conventional solution of addressing this excess capacity by shutting down production has become a political hot potato given the strong support these firms and investments have from the local party bosses and the large numbers of people they employ. The result is that even these aforementioned capacity utilization rates understates the true magnitude of the problem.

Thursday, December 24, 2009

The Gujarat government have recently passed a legislation making voting in local government elections compulsory. If the voter fails to vote for the reasons other than prescribed in the rules, he may be declared a "defaulter voter" and would face consequences for which rules will be framed and approved in due course.

Mandatory voting is sure to raise opposition among liberals who reject it as being against the fundamental values of democracy itself. Further, on the implementation side, there are far too many imponderables that can come in the way of enforcement of any rules that seek to punish "defaulter voters". Further, apart from increasing awareness, there may be other effective means of mobilizing voter turnout, especially in low turnout urban areas, like "nudging" people to vote.

In this context, research into randomized experiments to increase voter turnout conducted during the 2006 US mid-term elections and 2005 German federal elections by Daniel G. Goldstein, Kosuke Imai, Anja S. Göritz, and Peter M. Gollwitzer carry great relevance. They conducted two experiments - a mere measurement treatment (asking people if they intend to vote, thus causing them to reflect on their intentions) and an implementation intentions treatment (asking people how they intend to cast their vote, thus making them plan) - and examined the outcomes for both one-shot goals (e.g., voting on Election Day) and open-ended goals (e.g., voting early or by post) with deadlines in either days or months in the future.

They found that "mere measurement increased voter turnout for open-ended goals and for proximal one-shot goals but not for distant one-shot goals. Implementation intentions increased voter turnout for both open-ended and one-shot goals in the near and long term." Therefore, when elections are just around the corner, or when open-ended early-voting options exist, the mere measurement treatment can nudge people to vote in larger numbers.

The Nudges blog points to voter mobilization techniques involving randomly sending letters, airing radio and print advertisements, phoning homes, or sending canvassers door-to-door making personal pitches, all of which seek to "nudge" voters into actually casting their votes. It was found that mobilization techniques involving direct contact (as opposed to the impersonal channels of phones, e-mails and advertisements), like sending volunteers to remind voters about the vote next day, is effective in significantly increasing voter turnout. In fact, research by Betsy Sinclair et al based on experiments conducted in 2006 Californian elections, have found that voter turnout increases more (by more than 9 percentage points) if you send a neighbor instead of a stranger to someone’s house.

Instead of taking the extreme step of making voting legally compulsory, governments interested in addressing the voter turnout issue may be better off "nudging" than "legislating" voters to cast their votes. During the last elections in India some of these were tried out, though they were of the impersonal mass outreach variant. In fact, such techniques are more likely to be effective in local government elections. Residential Welfare Associations (RWAs) and other local volunteers may be mobilized to remind voters about their voting responsibility, say two days before the voting, so as to avoid infringing with the restrictions on campaigning that come into effect 48 hours before close of polling.

Techniques that use the "mere measurement treatment" would also avoid controversies over covert campaigning (using this nudge experiment to campaign) and can be tried out in urban areas, which have the lowest voter turnout and where subversion of these campaigns are least likely. Further, people in these areas are more likely to respond to these signals given the higher level of "peer pressure effect" within communities. So maybe, it is time that NGOs and public interest organization take a leaf out of the aforementioned studies and recruit community volunteers to "nudge" people into voting, and thereby prevent the need to have such compulsory voting legislations.

Update 1 (3/11/2010)

Excellent summary of the nudge techniques being adopted by political parties in the US to get people to turnout for voting. A study by Yale professors Alan Gerber and Donald Green during the 1998 elections split 30,000 New Haven voters into four groups - some received an oversize postcard encouraging them to vote, others the same message via a phone call or in-person visit, and the control group received no contact whatsoever. The in-person canvass yielded turnout 9.8 percent higher than for voters who were not contacted. Each piece of mail led to a turnout increase of only 0.6 percent. Telephone calls, Gerber and Green concluded, had no effect at all.

Tuesday, December 22, 2009

Sauvik Chakraverti has a provocative op-ed in the Mint which claims that India’s bureaucracy is wasteful and cumbersome and advocates a "truly capitalist public administration" ("government comprised of magistrates, policemen, judges, jailors and hangmen—nothing more"). While not holding a brief for Indian bureaucracy and even being sympathetic to the accusation, the solution advocated is at best ignorant and at worst dangerous.

Apart from the highly simplified, to the extent of being obtuse, ideological position articulated, there is a shocking level of (wilful) ignorance about the application of abstract concepts like "new public management" to our context. Take the example of the "capitalist administration" of garbage collection, steered by "just one civic official" and "rowed" by the market, to replace the "department with many rungs, recruits thousands of sweepers, buys hundreds of trucks", with its "very big jharoo tender".

"We in India, too, face a spiralling government deficit. In all our cities and towns, huge bureaucracies have been set up which contribute nothing towards improving our lives or our urban environs. These must be sacked and the system of government service delivery drastically reformed. Further, if we save money by contracting out garbage collection, we will have more left over for building roads. In my book, roads and garbage collection must be top priority for all urban local governments — and both must be provided non-bureaucratically."

The underlying assumptions in this arguement include

1. Urban bureaucracies are grossly inefficient and contribute little or nothing towards improving our lives2. Huge amounts are being squandered by urban local bodies (and their bureaucracies) that is adding to the government deficit3. Contracting out garbage collection is more efficient and effective than done by government4. There are private contractors with adequate capacity to step into the shoes of the "department" and collect garbage.5. That private contractors can do garbage collection cheaper than the "department"6. That there are piles of money to be saved, which can be used to build roads

The reality is that most of our cities are run on shoe-string budgets, relying predominantly on property taxes and user charges (both lightly levied). India stands alone among major countries where urban local bodies do not get a meaningful share (in some states it is nothing) of the direct and indirect taxes collected by state and central governments. Urban local bodies, except in the metros (and here too small in proportion), receive hardly anything from the "government", to contribute to the "government deficit". And talking about deficits, if only our debt-averse local bodies could actually get themselves to borrow more (and of course the debt market to have the depth to supply the credit)!

About private contractors, one only needs to look at the litter of failed experiments, across cities, with civic services contracting (garbage collection, street-lighting, water and sewerage treatment facilities etc) to realize the shallowness of the "market". The perception that private contractors can do the same service, with better quality, cheaper than government is one of the most enduring fictions in the privatization folklore. For some practical evidence of such "market" interventions, see this, this, this and this.

Apart from all the aforementioned substantive problems, these canards do considerable dis-service to the final objective - efficient and cost-effective delivery of quality public services. Here are just two examples.

One, the perception that urban local bodies (or government "departments") are wasting massive financial resources, which can be saved to finance other activities, is oft-used by many (fiscally constrained) state governments to deny cash-strapped urban local bodies even the the meager resources committed under the Finance Commission recommendations. The slogan is - cut down expenditures and save money to increase revenues! People just don't seem to realize that delivering quality civic services costs handsome money, which has to come from both much higher user charges and share of taxes.

Second, the arguement that we can dramatically transform civic services in our cities by pulling out the "department" and bringing in private contractors is also fraught with dangerous implications. Given the serious problem of supply-side constraints associated with private contracting of works and services, it is only inevitable that there are failures and bad experiences (more failure than sccesses, atleast in the initial years) with outsourcing and privatization, which ends up discrediting the process itself. We need to look no further than the controversial water privatization in Cochamamba, Bolivia (or water supply O&M by Delhi Jal Board and electricity distribution franchising in Orissa) that put privatization on the backfoot and ended up becoming a rallying symbol for opposition.

And finally, Sauvik's priorities, garbage collection and roads, are at odds with the priorities of just about any civic specialist (not just officials and public representatives) which are water and sewerage, along with solid waste treatment. Incidentally, roads, though very important, come much later, so much so that the Government of India refuses to sanction road works under the JNNURM.

None of this is to decry private participation in urban civic services (regular readers of this blog will appreciate its position on the debate!). Nor is it a defense of the department. This is only a note of caution against embracing attractive ideological shibboleths ("city managers using NPM")that grossly simplify the complex challenge of delivering public services in extremely challenging environments with scarce resources. We need "practical public administration" and not "capitalist public administration".

Monday, December 21, 2009

Marginal Revolution draws attention to a WSJ article that appears to indicate an increase in traditional money lenders even in areas with heavy concentration of microfinance activity.

The RBI has reported that the number of registered traditional moneylenders increased 56% to 19,627 from 12,601 between 1995 and 2006. Another survey has estimated that the traditional moneylenders' share of total rural Indian household debt grew to 29.6% from 17.5% since the nineties when microfinance movement took-off.

Interestingly, WSJ sees moneylenders and microloans as complementing each other, in so far as SHG members may be drawing on moneylenders to help them keep their repayment deadlines and avoid the very powerful peer embarassment. The argue that since moneylenders may actually be helping SHG members repay their microloans in time, atleast some of the MFIs may have been bankrolled by moneylenders themselves. In this paradigm, moneylenders and MFI are some form of complementary services! Econ 101 defines two goods or services as complementary when they are bought and used together, the demand for one mirrors that for the other and vice-versa.

Speculating about the growth of moneylenders, as evidenced in the aforementioned figures, there are a few silver-linings -

1. It is possible that the proliferation of MFIs has forced moneylenders out into the open and made them register their activities. In other words, the growth of MFIs has generated a positive externality - competitive pressure on moneylenders to become more efficient (and thereby access formal sources of funding mechanisms) and transparent. Further, to the extent that older moneylenders are now getting themselves registered, the true numbers of newly enterant moneylenders may be exaggerated.

2. Even assuming that the numbers of moneylenders have been increasing, it may only underline the severe credit stress faced in rural India. One indication of this is the fact that official figures show the rate of banking credit and deposit growth as being much higher in villages than cities. A recent article in Businessline estimated the appetite for microfinance at about Rs 1.30-lakh crore a year, whereas microfinance disbursements were about Rs 28,000 crore in 2008-09.

In other words, thanks to the increasing penetration of economic growth into villages, the rural credit demand may be rising at a rate faster than what both the banks and MFIs are able to meet. And moneylenders may be only stepping in to fill in the vacuum. So we should be having more aggressive outreach of microfinance. It is also one of the most important arguements in favor of banking access and strategies like Total FInancial Inclusion (TFI).

Sunday, December 20, 2009

It was naive to expect that a high-profile climate change summit at Copenhagen would have resulted in any quantifiable and binding emission reduction targets for two simple reasons. The costs of reduction are substantial, salient, and immediate, whereas the benefits (while substantial) are intangible, diffuse and long-term. Behavioural psychologists have a classic application of prospect theory - small and intangible benefits Vs moderate and tangible costs. More fundamentally, for the political masters, the costs are suicidal (or atleast result in losing votes) while benefits are not going to win votes.

After nearly two weeks of acrimonious discussions, the representatives of nearly 200 member nations finally cobbled up a non-binding Copenhagen Accord on climate change. The Accord, which does not contain specific emission reduction targets, sets the goal of limiting the global temperature rise to 2 degrees Celsius above pre-industrial levels by 2050.

One thing though is of great relevance. Given the weight pulled by the big emerging economies led by China, India and Brazil, the Copenhagen summit may be a bellwether of the future of multi-lateral negotiations in other areas (trade, capital flows and financial market regulation, arms trade, nuclear proliferation, labor flows etc). This also means India should be willing to assume the greater responsibility of not just blocking (or appearing to) unfavorable multi-lateral agreements on moralistic grounds, but pro-actively craft out negotiating positions (say, draft agreement alternatives) that protect our interests while keeping in mind the larger objective of such agreements.

Saturday, December 19, 2009

One of the most interesting policy debates during the current recession has been over the most effective fiscal policy options to combat the situation. Broadly, the divide has been over which of the two types of policy alternatives - tax cuts and direct spendingmeasures - is superior.

Supporters of tax cuts claim that tax cuts increases the disposable incomes in the hands of individuals and firms and thereby incentivizes them to consume and invest, and is therefore the least distortionary of options. They also point to the relative ease of implementing tax cuts against the well knwn lags in direct spending measures.

However, the supporters of tax cuts may have overlooked the fact that while tax cuts may be an effective (even the better) policy during a normal recession, it may not be an appropriate remedy for the present times. The current recession is exacerbated by the zero-bound induced liquidity trap, which sets in motion a set of rational expectations that are likely to end up perversely affecting indirect measures like tax cuts. In view of the fact that recessions which come along with a zero-bound in interest rates are very rare (the only major such recession being the one faced by Japan at the turn of the century), all available literature examine only the regular economic contractions.

Paul Krugman points attention to a paper by Gauti Eggertsson that examines the types of fiscal policies that are effective at zero interest rates and finds that direct spending policies score over tax cuts. Eggertsson's model finds that when the economy is facing the zero-bound (liquidity trap), tax cuts, on both capital and labor incomes, are contractionary and deflationary spiral takes hold.

Standard New Keynesian models have long argued that when an economy is faced with liquidity trap, tax cuts on capital income unleashes rational expectations that encourages people to save the additional income instead of investing it - paradox of thrift. In Eggertsson's model, cutting taxes on labor income expands labor supply, and puts downward pressure on wages. The resultant deflationary expectations increases the real interest rates and lowers both output and employment. A "paradox of toil" is the result!

Fundamentally, at zero-bound, the economy faces insufficient demand and therefore only fiscal policies that directly stimulate aggregate demand can succeed. Such policies include a temporary increase in government spending and tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply (such as an investment tax credit or a cut in sales taxes). Greg Mankiw recently advocated investment tax credits to incetivize businesses to invest.

The contractionary effect of tax cuts is understandable given the fact that they have no direct effect on consumption spending and investment. The labor and capital income tax cuts increases the supply of disposable incomes in the hands of individuals and businesses respectively, incomes which they can either save, use to pay off debts, or spend/invest. In the prevailing conditions - deflationary and recessionary - both consumers and businesses are more likely to either save or pay off debts, than spend or invest.

Eggertsson's verdict on the debate is fairly conclusive,

"Policy makers today should view with some skepticism empirical evidence on the effect of tax cuts or government spending based on post-WWII US data. The number of these studies is high, and they are frequently cited in the current debate. The model presented here, which has by now become a workhorse model in macroeconomics, predicts that the effect of tax cuts and government spending is fundamentally different at zero nominal interest rates than under normal circumstances."

See also Casey Mulligan's take on the "paradox of toil", one that again ignores the specific circumstances.

Friday, December 18, 2009

The focus of modern central banking has been to provide price stability by controlling inflationary pressures on the prices of goods and services commonly traded in the real economy. It was also argued that they should desist from trying to prick asset bubbles in financial markets and smoothing the booms and busts of business cycles.

This orthodoxy was best exemplified by a famous paper co-authored by the present Fed Chairman Ben Bernanke with Mark Gertler, and presented at the annual Jackson Hole enclave in 1999. Central Bankers led by Alan Greenspan have dutifully followed this strategy, even as the world economy developed serious macroeconomic imbalances and financial asset bubbles during the last two decades.

They have believed that it was not possible to accurately assess whether and when asset price increases assume the character of a bubble. Further, even if a bubble was developing, assessment of the time, extent and scope of the intervention required was thought to be beyond the abilities of policymakers. And compounding the problem is the difficulty in choosing the right mix of instruments to deploy in such situations. The dilemma facing central bankers is - when to intervene, by what extent and using what instruments? The risk was of intervening either too early and/or too aggressively, and thereby adversely affecting economic growth.

However, in light of the dramatic events of the past fifteen months and the havoc wreaked by the systemic risks that got built up due to the passivity of Central Banks, it appears that the momentum may have shifted in the direction of more aggressive Central Bank intervention to deflate asset price bubbles and stabilize the business cycle.

I have blogged earlier about using Markov regime-switching analysis for a variety of major global market events to detect advance signs of emerging market turbulence and manifestation of systemic risk building up. Further, as the figure below indicates, it is amply clear that asset prices have exhibited "irrational exuberance" on multiple occasions due to varying factors since late nineties.

WSJ points to the work (see this presentation) of Princeton Professor Hyun Song Shin and New York Fed researcher Tobias Adrian, draws attention to the impact of monetary policy on the funding conditions of financial institutions and development of financial asset bubbles. They show that the credit bust was preceded by an explosion of short-term borrowing by US securities dealers such as Lehman Brothers and Bear Stearns. They point to the borrowing in the so-called repo market (where Wall Street firms put up securities as collateral for short-term loans), which more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. Further, as the value of the securities rose, so did the value of the collateral and the firms' own net worth, in turn spurring firms to borrow even more in a self-feeding loop. And when the value of the securities started to fall, the loop went into reverse and the economy tanked.

In other words, "the most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices". The commonest policy intervention to prevent the build up of such levels of debt, and thereby pre-empt these busts, is to raise interest rates. Accordingly, Adrian and Shin highlight the need to factor in the trends and directions in credit flows ("balance sheet quantities") into Fed interest-rate calculations. They feel that small additional increases in rates in 2005 might have tamed the last bubble, and claim that interest rate is the "most effective instrument" for regulating risk-taking by firms.

However, this too runs into the same aforementioned uncertainties, risks, and inefficiencies. Interest rate decisions not only affect these financial institutions, they also impinge on all types of consumer spending and business investment decisions. Further, its universal sweep means that even the more prudent and responsible financial institutions are penalized for the excesses of their greedy and irresponsible compatriots. Or are there broader systemic parameters, which reflect the build-up of more universal distortions, that can be used to time such interventions?

A more effective and systemic intervention to prevent such debt spirals would be higher and uniform (across all types of financial institutions) capital adequacy ratios or tighter collateral requirements on borrowings. And these ratios should also take into account the varying extents of systemic risks posed by different financial institutions - remember the too-big-to-fail (TBTF) institutions! A sliding scale of increasing capital requirements as debt levels increase may help offset the amplified risks posed during such borrowing binges. Restricting leverage would have to become the primary control mechanism. Differential provisioning requirements, based on the investment risk profiles, are another excellent means to limit excessive build up of credit in high-risk sectors.

Update 1Mark Thoma draws attention to Paul Volcker and Ben Bernanke who both advocate an important role for the Fed in regulation and supervision of banking sector, especially in light of recent events which conclusively demonstrates that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined.

Bernanke's arguement rests on two issues - such powers significantly enhances the Fed's ability to carry out its central banking functions (the Federal Reserve’s ability to effectively address actual and potential financial crises depends critically on the information, expertise, and powers that it gains by virtue of being both a bank supervisor and a central bank); the twin functions of consolidated supervision of individual banks and assessing macroprudential rystemic risks require expertise that only the Fed possesses.

Update 2Rajiv Sethi feels that it "might be possible to obtain information about the prevalence of beliefs about an asset bubble by looking at the prices of options... In the case of a bubble involving a large class of securities (such as technology stocks) a widespread belief that prices exceed fundamental values should be reflected in higher prices for index straddles: a combination of put and call options with the same expiration date and strike price, written on a market index."

Thursday, December 17, 2009

"He never forgot that markets can malfunction terribly... good macro policies come first. Monetary and fiscal policy had to be employed to assure more or less full employment. Exchange rates had to be adjusted to assure competitiveness. Only then could the virtues of markets come into play. It was a lesson that too many economists forgot, as they immersed themselves in the lovely math of perfect markets. But Samuelson’s realism – his understanding that markets are great things but need to be supported by government activism — has never seemed more relevant than it does now."

See also this and this (from Paul Krugman), on his prescience about the ineffectiveness of monetary policy in deep slumps and how monetary expansion just piles up in bank reserves, extremely relevant now...

"Even if the authorities should succeed in forcing down short-term interest rates, they may find it impossible to convince investors that long-term rates will stay low. If by superhuman efforts, they do get interest rates down on high-grade gilt-edged government and private securities, the interest rates charged on more risky new investments financed by mortgage or commercial loans or stock-market flotations may remain sticky. In other words, an expansionary monetary policy may not lower effective interest rates very much but may simply spend itself in making everybody more liquid...

In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. 'You can lead a horse to water, but you can’t make him drink'. You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs. You can get some interest rates down, but not all to the same degree. You can tempt businessmen with cheap rates of borrowing, but you can’t make them borrow and spend on new investment goods."

See this and this from MR, this from Mark Thoma, this from TCA Srinivasa Raghavan, and this superb homage from Ed Glaeser ("Samuelson gave economists our toolbox"). Mostly Economics has this linkfest. See also Avinash Dixit here.

Wednesday, December 16, 2009

That the existing Self Help Groups (SHGs) based micro-finance model has achieved remarkable successes is delivering both social and basic economic empowerment of women in many developing nations cannot be disputed. However, the prevailing model, especially in the government led micro-finance schemes, suffers from important limitations that come in the way of achieving goals that go beyond the modest initial objectives.

Here are four fundamental problems with the micro-finance based poverty eradication model of delivering development.

1. The rigidly structured (10-15 members and lack of flexibility with changing its composition and size) group account oriented micro-finance model does not have the required flexibility to accommodate the differential savings habits of members within the group. Since there is only one servicing account for the group, all the members generally save the same amount and equally share any benefits. Therefore, instead of need-based loan uptake, more often than not the loans are equally divided among the members and resultant sub-optimal utilization. This becomes critical, especially when the group has achieved a level of empowerment, and the differential credit needs of group memebers assumes importance.

2. In the absence of access to innovative and beneficial financial products, the SHG members may not be able to make the most efficient use of the inculcated savings habits and financial inclusion. In fact, currently the high opportunity cost (given the scarce income and multi-farious competing needs) thrift is being locked up in the low yielding savings bank account of the group. Unfortunately, even as the focus has been to get people to save and open bank accounts, important issues like the returns on their savings have been lost in the maze of priorities. Further, not enough attention has been paid towards leveraging the savings to minimize the risks associated with the universal and commonplace needs like health care and children's education.

3. The present arrangements also do not place the required premium on the vital forward and backward linkages like access to intermediates and capital goods, markets, and training required for making the most optimal use of the financing available for self-employment generation opportunities. It may be more appropriate if the financing, especially for starting new businesses or expanding existing ones, be bundled with all the required forward linkages.

4. It does not more explicitly acknowledge the reality that SHGs and microfinance are at best an entry-point activity that should be used to propel the group members into a higher growth trajectory. This would require that the groups leverage on the platform provided by the SHGs to access the formal institutions that support them and then its members get gradually equipped to chart out their fortunes independently. It needs to be acknowledged that while the strength of the group is an excellent platform to address the problems facing a group of poor people struggling to survive, it may not be the most efficient vehicle for addressing the challenges faced by those positioned to move up the economic ladder.

However, contradicting the commonly held view that speculative activity is behind price increases, based on the aforementioned price trends, it is being claimed that "there was a nil or modest rise in prices of traded items, price rise was maximum in articles such as vegetables, fruits, tur, rice and sugar that are not traded".

CP Chandrasekhar and Jayati Ghosh draw attention to the sharp spikes in commodity (both foodgrains and cash crops) prices since second half of 2007 and early 2008 and the absence of any satisfactory enough demand-side explanation for such price increases to lay the blame on the doors of speculative activity triggered off by the flood of capital into deregulated exchange-traded futures and over-the-counter forward markets. See also this on the pronounced impact of global foodgrain price volatility on developing countries.

The arguement of Chandrasekhar and Ghosh rests on the claim that foodgrain prices have been experiencing larger than normal volatility in the last few years, as these graphics indicate

... and this graph of annual international price indexes for food and energy raw materials, 1960 to 2007 (2000 = 100)

However, it cannot be denied that speculative activity may have had atleast some effect on sugar prices, by way of the impact of futures price signals on wholesale market prices (and then transmitted down to the retail market). The true extent of this impact can be gleaned only by closely comparing and examining the spot prices with the prices of sugar futures (not able to lay hands on data). But given the imperfections in the transmission of such signals here, it may only have been a minor contributory factor towards the rises in prices.

Further, see also this, this, and this examination of the reasons for the commodity price increases. Also this Vox article which feels that the food price volatility wll persist.

Sunday, December 13, 2009

After "Save More Tomorrow" and "Give More Tomorrow", here comes "Save to Win". It seeks to structure the "choice architecture" in such a way as to encourage people to save more by drawing on insights from behavioral economics that people tend to over-estimate the odds of rare events.

Peter Tufano of HBS has devised "Save to Win" as a cross between a Certificate of Deposit (CD) and a lottery ticket, and it was launched for members of eight credit unions in Michigan. Under the Michigan scheme, members of the credit union who put $25 or more into a Save to Win one-year CD (which pays a rate slightly lower than rates offered by conventional CDs) are entered into a monthly "savings raffle" for prizes up to $400, plus one annual drawing for a $100,000 jackpot. In other words, they get both interest return from the CD and the (over-estimated!) prospect of hitting the jackpot.

Another example of such savings-cum-lottery instruments are the Irish Prize Bonds, offered in units of €6.25 with a minimum purchase of 4 units, which are a unique form of tax and risk-free, state guaranteed investment offering you the chance to win big cash prizes in a weekly lottery.

Marginal Revolution draws attention to an extract from William Poundstone's new book, Priceless: The Myth of Fair Value (and How to Take Advantage of It), which dissects the marketing tricks built into restaurant menus.

An explanation of the typography, location of items etc is available here.

Update 1Times has this article about how restaurants are embracing techniques from behavioural psychology to beat the recession - "magic combination of prices, adjectives, fonts, type sizes, ink colors and placement on the page can coax diners into spending a little more money". It draws attention to the considerable new research into the science of menu pricing and writing.

Saturday, December 12, 2009

This is no call for protectionism, but only an advocacy for a level playing field. It can no longer be denied that China's, recession-neutral, break-neck paced export-driven growth policies is causing considerable and ever increasing collateral damage on other developing countries and on the world economy at large. The time has surely come to address the challenge posed by these "beggar-thy-neighbour" policies squarely, failing which acrimonious international trade disputes are inevitable.

It is by now widely acknowledged that China's gargantuan appetite with accumulating savings and dollar reserves unleashed highly destabilizing macroeconomic imbalances in the global economy, which manifested in the sub-prime mortgage bubble and the subsequent economic recession. A determined focus on export promotion, preference for savings over consumption among Chinese, and an obsession with accumulating forex reserves have been responsible for this strategy.

The Chinese government's single minded obsession with an export-driven growth strategy has generated massive distortions domestically, which confers substantial unfair advantages for Chinese exporters over their competing developing country counterparts. Chinese firms enjoy numerous direct and indirect subsidies and supports that are not enjoyed by their competitors in other developing nations. For a start, the policy of keeping the renminbi tagged to a declining dollar means that its currency depreciates against the floating (partial and full) currencies of other emerging economies, thereby making Chinese exports more competitive.

The massive domestic savings glut and the limited depth and breadth of Chinese financial markets hepls government keep deposit rates artificially low which in turn means that its private companies can access capital at very cheap rates. The large over-capacity in many core sectors like steel, cement, aluminium etc and in many manufacturing industries mean that producers are able to effectively dump their products at prices that cannot be matched by their global competitors. The cost of other essential inputs like power, water etc are much lower than elsewhere.

The obsession with export promotion also means numerous tax concessions that too confer greater pricing flexibility. All this in addition to other direct production and export subsidies, including that from the $560 bn fiscal stimulus. Further, other indirect supports like keeping wages low and ease of land acquisition for setting up production facilities also means that Chinese corporates can focus their expenditures on issues directly related to production. In any case, the huge economies scale of Chinese manufacturing production already provides considerable pricing advantages in all sectors.

As the Times reports, the chorus against China's trade policy is mounting. The APEC has called for "market-oriented exchange rates" and atleast some members of the ASEAN are considering a review of tariff reductions agreed under the free-trade pact with China. India has filed a number of unfair trade practices compalint against China with the WTO. A spiral of competitive devaluations with very adverse consequences is a real possibility. This graphic captures the trend with the example of trade in nails.

As I have blogged earlier, it may be time to call the Chinese bluff with its cosmetic infrastructure investments in Africa and elsewhere and forge common front with other major emerging economies like Indonesia and multilateral platforms like ASEAN to confront the unfair export subsidies, direct and indirect, enjoyed by Chinese companies that make them competitive at the expense of their developign country partners. In the absence of immediate action, the voice from the giant Chinese manufacturing machine will grow louder as it sucks more and more jobs out from other emerging economies.

Update 1And now comes more direct "job sucking", as Chinese contractors insist on carrying construction workers from China for their external projects. From January to October 2009, Chinese companies completed $58 billion of projects, a 33% increase over the same period in 2008, and from Angola to Uzbekistan, Iran to Indonesia, some 740,000 Chinese workers were abroad at the end of 2008, with 58% sent out last year alone, according to the Chinese Ministry of Commerce.

Update 2Paul Krugman estimates the negative shock of Chinese beggar-thy-neighbour policy to be 1.4% of world GDP, and causing 1.5 million jobs in America.